Tech Sector Outlook 2008: Part 1

What S&P sees ahead for semiconductors, chip equipment, computer hardware, storage, electronic manufacturing services, and systems software

by Scott Kessler

Technology stocks have had a nice run in 2007, largely thanks to healthy demand for PCs with new software products, and exciting new gadgets like Apple's (AAPL) iPhone. The sector moved up in the first half of 2007, then retreated during the summer and autumn, along with many other sectors, amid worries about the U.S. economy caused by the subprime mortgage meltdown. So far this year, through Dec. 13, the Standard & Poor's Information Technology index gained 15.9%, handily beating the 4.9% rise in the S&P 500-stock index.

Standard & Poor's Equity Research has an overweight opinion on the information technology sector and an associated positive fundamental outlook. We believe technology companies and stocks should benefit from healthy domestic spending from enterprises and on consumer electronics, strong international demand, and new product and upgrade cycles.

We also see valuations as attractive, especially on a price-earnings-to-growth basis. Moreover, we believe many technology companies are rightly focused on delivering shareholder value, and are employing buybacks, strategic mergers and acquisitions, and restructuring/realignment efforts to provide it.

Here's the first of a two-part rundown of our IT analysts' outlooks for tech subindustries and stocks, covering semiconductors, chip equipment, computer hardware, storage, electronic manufacturing services, and systems software. Part 2, featuring outlooks on application software, Internet software and services, home entertainment software, IT consulting and data processing services, and telecommunications services and communications equipment, will follow on Dec. 24.

Semiconductors

Analyst: Clyde Montevirgen

We have a positive fundamental opinion on the semiconductor industry. Although strong unit demand in 2007 was balanced by less favorable average selling prices (ASPs), plant utilization rates rose and inventory levels burned off, providing a good starting point for the industry, in our view. We see memory chipmakers reducing manufacturing equipment orders and microprocessor producers benefiting from server and higher-end notebook demand, leading to better ASPs ahead. We expect sales to increase by 5% in 2008, moderately above the estimated 4% in 2007, and believe that this acceleration, combined with more favorable operating leverage, will lead to relatively high earnings growth, compared to that of other S&P industries.

But unlike 2007, when we saw various supply and inventory problems, we are somewhat concerned about the demand side of the equation. Economic risks stemming from the credit and housing markets could possibly limit enterprise and consumer spending ahead. Although we project sales advancing at a faster pace next year, our growth projection is lower than it was a few months ago due to higher economic risks we foresee and limited end-market demand visibility. Because of our increasing risk view, we have a more cautious opinion on the industry's relative valuations.

We are positive on companies we think will be able to advance in the face of possible economic headwinds by gaining market share in their respective segments, or on companies with very attractive valuations and solid growth prospects. We currently have buy recommendations on Intel (INTC; $26), Broadcom (BRCM; $26), Cypress Semiconductor (CY; $35), On Semiconductor (ONNN; $8), and Volterra Semiconductor (VLTR; $12).

Semiconductor Equipment

Analyst: Angelo Zino

Our outlook for the S&P semiconductor equipment industry is neutral.